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Podcast: Ch.1 Sifting Through the Noise and Taking Action – A Chat with Garrett Baldwin

Podcast: Ch.1 Sifting Through the Noise and Taking Action – A Chat with Garrett Baldwin

When I started out in finance, and even now, I get bogged down whenever I read certain financial news outlets. Even after years in the industry, it is tough to weed out what’s important and who is credible.
That’s why I asked Garrett Baldwin, an esteemed financial journalist, academic and the managing editor of AlphaPages.comFutures MagazineModern Trader, and FinAlternatives to be a guest on the podcast.

In this episode, we talk about a variety of topics including Garrett’s journalistic process,  holding Wall St. analysts, journalists and bloggers accountable, and tips on building an investment process.

Check out the podcast to learn how financial journalism is changing and how the latest financial technology tools can help us sift through the noise to find meaningful, actionable data.

Garrett also mentions the Tiingo community in the cover story of his newest publication coming out:  Modern Trader (Available June 23rd at Barnes & Noble, E-mail will be sent out).

Here are a few resources we discussed in the episode:
Modern Trader

Garrett is the Managing editor of, Futures Magazine, Modern Trader, and FinAlternatives. In this episode, we touch upon a variety of topics including the journalistic process in finance, holding Wall Street analysts and bloggers accountable, and tips on building an investment process. Learn how financial journalism is changing today and how the latest financial technology tools can sift through the noise and find meaningful, actionable data.

iTunes Link

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Given the back-and-forth nature of this Episode, there is no transcript.

Podcast: Ep.7 Our First Hedge Fund Strategy

Podcast: Ep.7 Our First Hedge Fund Strategy


In this episode we cover not only what hedge funds are, but one of the most recently used hedge fund allocation strategies: risk parity. The largest quantitative hedge funds are using this method and it is now presenting some real dangers. We use this example to touch upon how we can skeptically look at performance and also what to beware of with 13F filings. This episode synthesizes everything we’ve learned into a single practical episode.

iTunes Link

Non-Itunes (

Here is the script that was used in today’s episode.

Note: I don’t follow scripts word-for-word as they can sound unnatural, but the episodes do closely follow them.

Get excited listeners. We’re going to synthesize everything we’ve learned to create our first hedge fund strategy and go over what a hedge fund is. If you haven’t listened to the other episodes, that’s okay because this can be a good test to see if you need to brush up on anything. For the most part though, this will be a very simple explanation so relax and enjoy listening.  Oh! And I even made an entirely new feature and initiative on Tiingo to aid in this episode.  Actually, I had this podcast all scripted out and then I realized, “I should just make this hedge fund tool for everyone.” So… this is going to be a really fun episode.

I consider this an important episode because we’re going to be using some metrics we’ve learned about and touching upon new ideas like risk management and position sizing and what they mean. We’re also going to discuss criticisms of the hedge fund strategy we’re covering, which will give you a look into how we should all view markets and claims made by individuals. One of the most important skills you can develop as an investor and trader is skepticism.

Here is a fun story that upsets me quite often. I used to work at a big bank, and there was a Managing Director there. A managing director is the most senior title you can get at a bank before you get into CEO or CTO.  In other fields it may be called a Principal, Partner, and so on. Point is, it’s a very high title. Well this MD, managing director not medical doctor, was followed across wall street because his research was popular. What the bank didn’t advertise was that this MD originally traded, but because he lost money for 7 years straight, they no longer allowed him to trade with bank money and instead allowed him to publish research because it helps their relationships with clients. Another fun point? Of the people who read his research, half of them mocked him and used him as a joke of everything wrong in market analysis. This MD would literally look at a price graph and then draw arrows. That’s it. He would circle things, and draw arrows where he thought things were going.

I rarely trash talk as you know in this podcast, but I bring up this example to highlight how important skepticism is. Even if you think somebody is a pundit or brilliant, fact checking is incredibly important. Misinformation is so dangerous because it means we can lose our money. It’s one thing if the misinformation is a genuine mistake and a person tried, it’s another if an institution knows a person had bad research yet still promotes him for sales. I will never stand for the latter and will continue to be vocal on this.

So to recap: always be skeptical. Even of me. Verify everything I say. I try my best but I am human so if you think I’m wrong, please check. If you don’t think I’m wrong, then definitely fact check me! Haha, that’s an important lesson!

OK moving on to some quick Tiingo announcements. This week we have revamped the entire fundamental database so it has the data structured in tables as well as graphs. The data is now also more accurate and had extensive coverage for over 3,500 stocks.  Secondly, I have started the Tiingo Labs initiative, which contains a powerful tool you can use with this podcast. And thirdly, I just added a chat reputation system, as well as something called a Tiinglet. I realized some of the best converrsations among friends happen within chats, but we don’t have a way to save them down. I present a Tiinglet, it lets you turn your discussion about markets into something you formalize and give to the public to help others learn. If you open the Tiingo chat, click a username of a message you like, a box will come up and within a few clicks, you will make a site centered around your dialogue.

For example, if you and a friend are talking about Apple and one of you comes up with great analysis you think you could help others, then you can simply click the text and a message box comes up that lets you turn the conversation into page that is accessible to others who may have the same questions as you do.

In addition, if you like the Tiingo project – the mission, podcast, web app, and so on, please consider paying for Tiingo at once again I have a pay what you can model so nobody is excluded, but in order to exist, we will need people to pay for the product.

So let’s move on into our first hedge fund strategy!
To begin let’s discuss what a hedge fund actually is and how news can often misinterprets what they do.

A hedge fund’s goal is to make money that’s uncorrelated to other assets like stocks, bonds, and so on. Think of it as if you invested in real estate. If you bought a condo,you probably wouldn’t compare it to stocks. In fact, many times people invest in property to build equity or have other investments besides stocks and bonds.

So it’s not so much hedge funds have to make more money than the stock market like the S&P 500 or NASDAQ index funds, but that they have to have a return stream that differs from those.  They are a tool used by pension funds, wealthy people, banks, other institutions, and so on to diversify away their risk. For example, if you had 10 billion dollars, stocks and bonds may be nice, but you may want to have other investments too like real estate. So think of a hedge fund as a tool used by wealthy investors to diversify away some of their risk.

You may often see headlines that say, “the stock market returns 20% this year, but hedge funds only returned 12%.” But that’s not a bad thing. A hedge fund’s goal isn’t to beat stocks, it’s be uncorrelated for stocks. For example, if stocks were up 20% and a hedge fund was up 20%, and if stocks were down 10% and a hedgefund was down 10%, why would you pay fees to a hedge fund when you could own an index fund?

So to create strategies uncorrelated to the stock market or bond market, a hedge fund will trade in different styles. They are considered active managers. They also have a tool called leverage. This simply means they can borrow money. If they have $10,000, they may trade as if they had $50,000. They can also sell short, a topic we covered in Q&A. This differs significantly from mutual funds and index funds, which tend not to really use leverage in the same way, and also mutual funds and hedge funds don’t sell short. Because of this, hedge funds are often classified as an “alternative investment.”  They are alternatives to traditional assets like stocks and bonds. They manage money in what is considered non-traditional ways.

Some hedge funds may be long a stock while being short another stock. This is called a long/short equity fund. Others may trade commodities or fx, and these are often called global macro funds. Some hedge funds employ quantitative strategies where they build computer programs that decide what to invest in.

One problem you see in the

The fee structure for a hedge fund is often more aggressive than a mutual fund or index fund. It’s typically assumed a fund takes 2/20 (2 and 20) or maybe you will see 1.5/15. Let’s use 2/20 as an example. The first number, 2, is the management fee.  This is similar to a mutual fund. If you invested $1mm, you would pay 2% of what you invested. IN this case it would be 2% of $1mm, or, $20,000. The second number, 20, is the cut they get based on performance. For example, if they make 15% on $1mm, or $150,000, they will get a cut of that $150,000. The second number represents the % cut they get. So if it’s 20%, they would get 20% of $150,000 which is $30,000. So 2/20 (2 and 20), is a 2% management fee on what’s invested, and a 20% performance fee which is shaved off the additional money they make. If the hedge fund doesn’t make money, or losses money, they still get the management fee but do not get the performance bonus. They get the 2% but not the 20%.

So a hedge fund is a pooled investment, like a mutual fund or index fund, but they take investor’s money and then use alternative strategies to make money in different ways. Their goal is to make money regardless of market conditions while also being uncorrelated to other assets. As usual this should be the case, but often time isn’t.

Anyway, this is what a hedge fund is. It often has a mystique to it like hedge fund traders are brilliant. But just like any profession, you have people who are very good, and others who may not be so good. Often I find the media portrays hedge fund managers, especially quants, as these super brilliant mathematicians. Having gone to that side, I can assure you…unless it’s High frequency trading, the Ph.D.s and the chess champions don’t make a difference.  They’re just normal people that are incredibly passionate about markets.

Now that we know what a hedge fund is, we are going to discuss a popular strategy using the knowledge we’ve gained. We need to understand volatility, correlation, and stock indexes and etfs.

So a hedge fund takes a non-traditional approach to investing. Do not try what we’re discussing at home. There are a lot of caveats to a strategy like this, some of which we’ll get into, but making sure this is done right takes a lot of practice.  I don’t want to be responsible for any execution errors or mishaps. This strategy is not guaranteed to make money, and in fact could very well lose you money. Anyway, with this very scary, yet important disclaimer aside, let’s move forward, woo-hoo!

We’re going to discuss a strategy called a risk-parity strategy. Actually, risk-parity is not a strategy but an allocation method. That simply means, it’s a method to determine how much money you should put in each asset you own. What I mean by that is if you own a stock index fund and a bond index fund, how much should you put in each? In episode 3 we discussed two different ways to determine this, one was simply always keeping 60% of your cash in stocks, and 40% of your cash in bonds. We spoke about how this is naïve because it stays the same regardless of other factors. For example, if you are younger, you may be able to take greater risks, which will let you be in more stocks.

In the same way, a risk parity strategy helps you decide how much to put in each stock. We’re going to use the 60/40, 60% stock, 40% bond, portfolio as an example for this strategy.

So a big trend among large hedge funds, like AQR and bridgewater, is to determine how much to put in each asset using a risk-parity strategy.  They may add a few twists to the idea, but at it’s base core, a lot of it is determined by this method.

So what is risk parity? Well it simply means equal-volatility weighting your portfolio. Before you shut off this podcast, I will actually explain what that means. I can’t stand when people define terms using equally difficult terms or phrases so I won’t do that to you.

So you know how in the 60/40 stock/bond portfolio 60% of our cash was in stocks, and 40% was in bonds? Well we generally assume stocks move around a lot more than bonds do. Bonds are assumed to be a bit more stable.  This is a concept we call volatility. We say, on average, stocks are more volatile than bonds.  Typically, many people measure risk as volatility. Something that moves around a lot, could be said to be more risky. So sometimes volatility and risk are sometimes said to be synontmous.  SO breaking down the term, risk parity, we can say volatility-parity. And parity means for something to be equal.  Using these definitions, we can say “risk parity” roughly translates to “volatility equal”, or more naturally, “equal volatility.” Risk parity means equal volatility.

But what does that mean practically? A common example is if you take a 60/40 stock/bond portfolio, and measure the volatility, we see 90% of the volatility comes from stocks, and 10% of the volatility comes from bonds.  Going forward we are going to use the term “cash.” This means exactly that. If we put 60% of our cash in something, it means if we had $1,000, we would take $600 and invest it in stocks. We would then take $400 and put that in bonds. a 60/40 portfolio is 60% cash in stocks, 40% cash in bonds.

If we took 60% of our cash and put it in stocks, and 40% of our cash  and put it in bonds, 90% of the movement would come from stocks. Only 10% of the movement would come from bonds.  Because stocks are said to be higher risk, or higher volatility in this case, they would make up 90% of the risk in your portfolio, even if they were only 60% of the cash.

So what risk parity says is that we should make stocks only take up 50% of the risk, and bonds make up 50% of the risk. If 60% cash results in 90% risk, how much would we have to scale back? Well if we put 33% of our cash in stocks, that would make the portfolio take up 50% of the risk.

What about bonds? Well since 40% cash results in 10% risk, if we multiply our bond position by 5, we can get 50% risk. That means we have to take the 40% cash position/10% risk position, and multiply both by 5. We can see that 200% cash in bonds results in 50% risk.

But how do we put 200% of our cash in something? Well this is a concept called leverage. This is something hedge funds can do as we mentioned earlier, they can essentially borrow money to multiply their returns.  Individuals can do this too through margin and futures, but we’re not going to cover this here quite yet as this is a more advanced topic and has serious risks involved.

So to recap, in order to take a 60/40 stock/bond cash portfolio, and make the portfolio 50/50 in volatility/risk, we have to cut the position of stocks and lever up the position in bonds.

Notice how we are using the volatility of an asset to determine how much to allocate? This is a dynamic method, and no different than if we did 60/40 or another allocation method. So risk parity just tells us how much to put into each asset. The strategy will tell you what assets, and risk parity will tell you how much to put in each asset.

So let’s get down to it, how much would this strategy make vs a 60/40 strategy? And here is where things are gonna get SO fun.

The risk parity strategy returned 45% total over the past 12 years. The 60/40 portfolio returned 61% total. This wasn’t assuming reinvesting dividends for those wondering – if you want to ask my why shoot me an E-mail.

So you may be thinking,”Rishi you said this was profitable…but I would make less? What is wrong with you.” Well here is the key information and why hedge funds can do this better than 60/40. We have to look at how this strategy performed relative to the path it took. In episode 5 we talked about volatility and how the path to the return we got matters. For example, if invested $100,000 and doubled our money to $200,000 that’s awesome. But what if half way through that $100,000 turned into $50,000?

Likewise, what if you invested $100,000 and made $150,000 but the lowest your portfolio ever got was $99,000. Which would you prefer? Even if you’re telling me the down $50,000 scenario, here is why it’s still worse if you’re a hedge fund.

The risk parity strategy had a volatility of about 5.5%. The volatility of the 60/40 was about 11%, almost double. So what a hedge fund will do is that they will apply even more volatility, because investors want a higher return. So to compare apples to apples, a hedge fund may use leverage and double the amount of money into risk parity, so you take that volatility of 5.5% and double it, and now you have 11% volatility. But you also have double the return.
So if we want to compare apples to apples, we should also compare the volatility, or the path it took us to get to the return we have. So if you double the leverage to a strategy, you not only double volatility but the return. So that 45% we made on risk parity becomes 90%. 90% on risk parity vs. 61% on a 60/40 portfolio. There are a bit more nuances to this strategy that actually improve performance of risk parity, but we’ll get to that soon enough in this podcast series.

If you want to play with this risk parity allocation method, I mentioned I created a tool to help you do this. Know this is an informational tool and you should not trade on the results. I have not put in tradeable assumptions, but this is a good informational off-the-cuff proof of concept. And please treat it as such, it’s not a full replication of the strategy nor how much you should invest. So with that diclaimer, check out the tool on You’ll see a link that has risk parity. This is a sweet tool that may let you get an idea. You just type in the tickers you want in your portfolio and press enter. Maybe you want to include the S&P500, bonds, but also small cap stocks? But anyway, the possibilities are endless and I hope you find joy and fun is playing around with this!

The next question we have to ask ourselves, is why does this strategy perform so well?

This is where skepticism in markets is so critical. If a strategy performs very well, it’s important to ask ourselves why? What conditions are allowing it to perform so well? Is it the economy, maybe government policy? Certain changes in technology?

In this case, the common explanation of why risk parity does so well is especially from the bond market. In the U.S., for the past 30 years, bonds have done extremely well. They’ve never really gone down for an extended period of time like stocks have. And after the 2008 crises, the Federal Reserve, which sets an interest rate that bonds are affected by have gone down. The Federal Reserve, or Fed, did this to promote credit and boost the economy. We will get into how that works later, but the take away is that fed policy has allowed rates, like loan or mortgage rates, to stay low. Not only that, awhile ago the Fed committed to doing that for awhile.

In Episode 5 we mentioned how uncertainty creates volatility. Well, when a book government agency that influences rates says, “we’re going to do this for a long time” it removes a lot of uncertainty. This in turn removes volatility from bonds.

So what we’ve seen are that bonds are performing very well, the price goes up. If you’re new to bonds, it’s said the price of bonds is inversely proportional to the interest rate. What that means is that if rates, like you see on loans, goes down, the bond is worth more. We will cover this more in depth later, but if rates are up, bond prices are down. If rates are down, bond prices are up.

So since the Fed committed to keeping rates low, you’ve seen bond prices go up. Secondly, you’ve seen a lot of uncertainty removed in the bond market, resulting in low volatility. And since risk parity equal-volatility weights, in order for the volatility to be 50-50 stocks and bonds, hedge funds have bigger positions in bonds.

So the argument against risk parity is that it applies an unfair amount of leverage to bonds. To mitigate this, hedge funds look at the volatility every month, and do what we call “rebalance.” If volatility was higher for an asset the previous month, they will put less money in the asset the next month. Every month they make take the average volatility for the past 3 months and add or reduce their position in each asset.

However, rebalancing happens once a month. What if the price of bonds fell quickly within a month. Let’s explore it for a moment.

In our example, we borrowed double our money to invest in bonds. Let’s say we had $1,000 and borrowed another $1,000. The $1,000 we had is our equity. So if bonds fell 50%, we would lose 50% of the combined value of $2,000. We would lose half, so $1,000, which would completely wipe out our equity.

If we levered 300%, so we had $1,000, but borrowed another $2,000, a 33% fall in bonds would be a loss of $1,000 and wipe out our equity. The equity is what we actually have, so if we lose all of it, we go bankrupt.

The truth is though, with hedge funds, if they are down 20%, investors get scared and often pull their money away. If your mutual fund was down 20%, you would probably rethink the investment.

Right now, a big worry among investors in hedge funds is that the economy has been doing pretty well. So when is the Fed going to allow interest rates to rise? And what if it happens really quickly? If rates rise quickly, the price of bonds will fall quickly. And remember, the top hedge funds are using this strategy and they manage $200bn among the top few alone. If these $200bn is highly levered, imagine how many billions could be wiped out if bonds just fall 10%.

This is similar to the 2008 crises. Many people were hurt because banks were offering low down-payment mortgages, and that just means people levered. a 10% down payment means you are levered 10:1, or 1000% on your equity. If your house dropped 10%, you were wiped out. This is what hurt people.

In the same way, a big worry is that because funds are so levered on bonds, if they fall in price, you could see billions of dollars wiped out. Funds have tried to come out and recognize this problem and are taking steps to address it. I wont comment specifically if I think these steps are appropriate, at least not publicly, so if you want to have that discussion, shoot me an E-mail!

The caveat though is that leverage needs to be used appropriately, and many people think the reason this strategy has done so well is because bonds have done incredibly well over the past 20 or 30 years. Stocks have also done very well in the past 6 years, so this keeps adding to the returns of the strategy.

These are the drawbacks and everytime you see performance numbers, always ask yourself why? Asking why an opportunity exists is not just a powerful tool in business, but also markets. Maybe there is a reason this strategy works that may make you feel uncomfortable.

Either way, I know this is a lot to take in, so if you have to repeat a few parts, I apologize. But this example is truly an expression of how we can combine the things we learned so far into a strategy the largest hedge funds are using.

This has been fun and if you have any feedback please E-mail me at [email protected]

Podcast QA2: What is Shorting and How Do People Make Money When Stocks Fall?

Podcast QA2: What is Shorting and How Do People Make Money When Stocks Fall?

Short-selling can allow somebody to make money when the price of a stock falls. I’ve been thinking for years on how to best explain this, because I myself struggled with this concept for a very, very long time. Luckily, I found a way! I share with you not only what short-selling is, but how it works, and what to be wary of. s.

With that! Here are the links. If you have iTunes please use that as it helps my rankings within the store. Don’t forget to subscribe to stay updated on future episodes!

iTunes Link

Non-Itunes (

Here is the script that was used in today’s episode.

Note: I don’t follow scripts word-for-word as they can sound unnatural, but the episodes do closely follow them.


Hey listeners, welcome to QA.2 What is shorting?

Today we are going to discuss, what is shorting? And how can you make money when stocks go down? What are the implications of doing this with commodities or other types of financial instruments? And of course, since this is the Tiingo Investing podcast, we aren’t going to just explain what shorting is, that’s way too easy. We’re going to take shorting and then expand upon the concept to take it a few levels deeper. Everything will be easy to understand I promise.

For those of you just listening in, this is a Q&A episode. In this format we answer questions directly from our listeners.  I personally love these episodes because it means I get to interact with you all and learn what’s important to you.  Actually it’s funny, before a user asked me to explain shorting, I would spend the past couple years thinking, “if I were to teach shorting, how would I do it?” The reason I’ve been thinking about this for years is that this was a concept I struggled with for sooooo long. I mean you google it and people are like “you borrow shares and sell shares you don’t own then buy them back cheaper” And that’s the explanation. And I was still left with so many questions like “wait what? how does this all work?”

So it took me an embarrassingly long time to learn shorting and I think part of it is that sites don’t explain it well. Well I’m looking to change that in this episode and luckily I’ve been thinking about this for years. Now, I wanted to put this in the episode series, instead of Q&A, but I couldn’t figure out how. After all, the goal in these beginning episodes is investing and smart longer-term strategies. Eventually I will get into trading, but it would kinda stink to wait until episode, I don’t know, maybe 20 to learn shorting? Especially since it’s so prevalent in the media. And when a user asked, I decided, “This will be a good Q&A episode.”

Anyway, I’m going to provide a better “what is shorting” education because I can empathize with the confusion of when you google it.

Before we begin, I do want to cover a few things regarding the pace of Tiingo’s future episodes. This is going to take a couple minutes but I want to be clear why the pace of episodes is slowing down a bit. Originally, I was aiming for 1 or more episodes a week, but the truth is that the majority of my Episodes take 16-20 hours each to plan and create. Not only that, my mind is constantly thinking about how to explain things at all times.  For those of you who don’t know what Tiingo is, it’s a broader mission to make high end financial tools and education accessible to everyone.  There is a trust vacuum in finance and investing, and I want Tiingo to fill it. It’s first and foremost mission is to Actively do good. The mantra don’t be evil isn’t good enough for Finance, so Tiingo adopts “Actively be good.”  I see Tiingo as a kickstarter except better as you’re constantly building a business that provides a service to the people.  There isn’t the risk of contributing toward a product that doesn’t make its final form or really fully develop. It’s continually improving.

Anyway,  creating Tiingo allows me to develop and manage a web platform, author a podcast, interact with my users and listeners, which I love btw, and now market to get the word out. Because of all these things the past few weeks I’ve been working 8am to 2 or 3am. Actually sometimes 4 am.  I’m currently a one-man shop and thankfully many in the community are volunteering their time to help out. But in order for me to exist as a person, I have decided instead of 1 or more episodes a week, I’m going to aim for 1 or more episodes every two weeks. This is important as now we are going to get into some more complex stuff and I want to spend a lot of time making sure it’s accessible. Also this release schedule lets me sleep at a reasonable hour and have time for friend, family, and my significant other.

So I hope you can understand if the pace of episodes going forward is a bit slower. I’m still giving the same amount of time, if not more, to each epsiode and that requires a bit of a longer release schedule.

Anyway, last quick thing before we get into it – the Tiingo ecosystem, platform, and community has a “pay what you can” page. Because Tiingo costs money to run and I want to empower, I believe right now this is the best model to create a sustainable business and also empower. If you have a few minutes, I would love it if you could go to and contribute. Even if it’s a couple dollars a month, if everybody does it, I can continue to support myself full-time. I’ve forgone over a year of income to create this project so it is helpful.  If every listener contributes $3/month or more, I can get one-step closer to making sure I can continue to do this full-time.  Think of this podcast as a constantly evolving book that interacts with us. Many of us spend $3/month on a cup of coffee, or for a book that doesn’t change throughout time. Well, why not spend another $3/month for Tiingo? Smiley face.  The link is

Anyway, that covers the pace of future episodes and a “I need to pay my bills” shpiel. Let’s move forward!

Shorting is a way somebody can make money when a stock falls. It’s a term for borrowing a shares of a stock, selling them, then rebuying the shares. You may be thinking, “uhhhh,” and that’s exactly how I felt when I heard this. So let me explain in easier terms because that explanation kinda stinks ….as usual I will explain with my favorite dessert: cookies

Let’s say your friend owns a cookie shop. You always stroll in his part of town because you buy his cookies. They aren’t any different than other cookies, and in fact your friend buys his cookies from a big company. This company sells their cookies in a ton of different stores.  Your favorite though is a bag of chocolate chip cookies, which sells for $10 a bag.

To make this scenario even more ridiculous, let’s say you’re a photographer. And you have an obsession with taking pictures of cookies. You love your friend’s chocolate chip cookies for $10/bag so much, you ask him, “hey can I borrow that bag for a hot second? I want to take a picture of it.”

Your friend thinks you’re a little creepy, but you’ve been a good customer so he says, “sure, just make sure you return the bag to me after you’re done.

You tell him that’s fine and borrow the cookies from your friend. You take some pictures of the bag, and have a friend over that night. Your friend looks at the cookies and is say, “they look so good. can I have some?” You tell him, “oh I’m just borrowing them for pictures.” Your friend who’s over looks at you funny and says, “Ok how much? I’ll buy them from you.” You realize your cookie shop friend would love it if you sold his cookies for him. So you say, “sure they’re $10.” Your friend pays you $10 and you put it on your wallet so you can give your friend the cash the next day.

The next day you walk to the cookie store to give your friend the $10 you made for him. You’re strolling along when you look to your right and see another cookie shop. You see the same cookies you just sold last night, but WAIT! you see the price….whoa.  This other cookie store is selling it for $5/bag…at your friends store they were charging  $10/bag yesterday.

You enter an existential crises of realizing you’ve been overpaying for cookies.  What is friendship? Would a friend truly make you overpay for cookies? Why would he do this to you? You’ve bought over 100 bags of cookies from him.  Why? You realize he’s not your friend and you never want to talk to him again. You say, “I don’t care about my friend, I’m going to go make a profit.”

You decide to buy the cookies for $5/bag from this other cookie shop. You go to your friends cookie shop and give him the new bag you just bought from the other store. He can’t tell the difference and thanks you. He then asks you if you want to buy cookies from him and he says the supplier dropped the cost and they are now $5 bag.

You smile because you realize he’s still your friend. You tell him no thanks and walk away.

So what just happened in this scenario? Well you borrowed the cookies from your friend, sold them that night for $10, then saw the same cookies selling for $5/bag in another store the next day. Your friend only asked you for the cookies back, but not the money. So you decided to buy a new bag at $5/bag.  You gave that bag to your cookie store friend and he couldn’t tell the difference: they were the same.

You just pocketed $5.

Once again, you borrowed a bag of cookies that normally cost $10/bag, sold them to somebody for $10 that night, and then bought that same bag of cookies for $5 the next day to give back to your friend. You sold the borrowed cookies at a higher price, then bought them back the next day at a lower price. And then you gave your friend who lent you cookies those new cookies to pay him back.

If this doesn’t make sense yet, it’s okay. Let’s continue on and talk through an example involving stocks.

Taking the perspective of stocks instead of cookies: Let’s say you see Microsoft is $40/share. You think for whatever reason the stock is going to drop. Well, you can go to your stock broker say, “hey can I borrow 10 shares real quick.” They say, “yeah sure, why not? Just give me 10 shares back at some point.”  Since pretty much all shares under the ticker MSFT, Microsoft, are the same, they don’t care if the 10 shares you give them are the ones they lent you or not. They just want 10 shares back. Remember, from episode 1,  because shares are identical, they can be traded on an exchange. 10 shares under ticker MSFT are going to have the same rights and benefits as the next 10 shares under MSFT.

So you borrow the 10 shares from your broker, and then you sell them at the market for $40/share. You collect $400 in cash for selling those 10 shares @ $40/share.

So now Microsoft drops to $35/share, and you think, “okay I’m happy here.” So you buy 10 shares @ $35/share, which costs you a total of $350. You give those 10 shares back to your broker.

Remember when you sold those borrowed shares, you made $400. Now you spent $350 to buy those shares back. Sell price minus buy price gives you profit. So you sold at $400 bought at $350. $400-$350 is a $50 profit.

OK now let’s get into some nuances.

When you ask your broker to borrow 10 shares, they actually ask a clearinghouse which has a “inventory” if you will of shares of Microsoft.  Think of them as sort of the “accountant” of your shares and everybody else’s at your brokerage. They help ensure the stock system is less risky.  Anyway, you want to borrow 10 shares and let’s say the clearinghouse has 1,000 shares of Microsoft on hand. They may say, “Ok that’s 1% of what we have that’s fine.”

But what if the clearinghouse only have 30 shares of Microsoft on hand? Well that 10 shares you want to borrow is now 30% of their inventory.

Think of this like a bank. When you go to your bank, you know the bank has enough cash to satisfy your needs if you want to take some cash out of your bank account. Well, what happens if every person who had an account at that bank asked for a cash withdrawal the same day? The bank would quickly run out of cash and not be able to service everybody. But the vast majority of the time, banks have enough cash to help people on a day-to-day basis.

The same principle holds for these clearing houses.  Their inventory of 1,000 shares of Microsoft exist, because all together, their customers have 1,000 shares. They have to make sure they have some inventory of Microsoft so if a ton of people ask to sell their shares, the clearinghouse can serve those people.

So they may feel comfortable letting you borrow 10 shares if they have 1,000 in inventory. But what if you asked for 10 shares of Microsoft when they have 30 on hand? That’s 30% of their inventory!

So to protect themselves they may say, “that’s fine, we can give 10 shares to you…but you’re going to have to pay up. You’re going to have to pay us a 50% interest rate because Microsoft right now is what we call, “hard to borrow.” You have to pay a 50% interest rate which is an annual rate. What this means, is that for every dollar you make from selling short, you have to pay 50% of it, or 50 cents each year, to the clearinghouse. So if you sold 10 shares of microsoft at $40, that’s $400. That’s $200 over the course of the year. Typically interest rates are based on 360 days to a year, so you take that $200 divide it by 360 days in a year, and that’s about $.55 a day to be short.

So if you bought back microsoft at $35/share, but it took you 100 days to do it, you would’ve paid $55 in interest to the clearinghouse.  Yet your profit was only $50. So with shorting it can not only matter if the stock drops, but also how fast it drops as you may have to pay a large interest rate, especially if it’s hard to borrow. With shorting you can very easily be in a race against time.

If you want to sell short you have to call and ask your broker what their rates are and how they handle the borrowing fee. Each broker will be different and have a different rate schedule. So before you sell short, please call them ahead. Some may charge additional fees.  This short selling interest rate process can very drastically from broker to broker. So my goal is for you to be aware that there are borrow fees and potential interest rates involved when selling short. It can get very broker specific.

The next nuance is something called margin. If you want to short, you have to open your brokerage account with margin approval. When you open up a brokerage account for the first time you can select this option .If you already have a brokerage account, you will probably have to fill out a separate form to request a margin account.

So what does margin mean? It can be confusing because it has two meanings. First, margin lets you borrow money to invest. If you have $2,000, you can apply for margin and double that. You can now trade as if you have $4,000. This is a concept called leverage. IN this case, you are levered 2 to 1. Or for every $1, you can trade $2. Remember, that your account is still only actually $2,000. If you didn’t use margin or leverage, your stocks would have to lose 100% to get wiped out and have $0 left over.

If you levered 2:1 and you traded as if you had $4,000, your account would have to lose 50% to be wiped out. So if you lost 50% of 5,000, that would result in $2,000.  So if you lost 50% when levered 2:1, you lose $21,000, which wipes you out. Using leverage can magnify losses and gains. And because of this, margin gets a second meaning. Margin is also the cushion you have. Remember the broker and clearinghouse want to protect themselves. So they may say, “okay, if you have $2,000 in your account, you can invest up to $4,000….but if your account drops below $1,500  you have to put more money in your account.” Each broker will set a different amount of what they feel comfortable with.

Because brokers and clearinghouses want to protect themselves, they will let you trade with leverage, but if you lose too much, they will ask you to transfer more money into your account. This is called a “margin call.”

But for short sellers the Federal Reserve Board requires if you short sell you have at least 150% of the value in your portfolio .For example, if you sold those 10 shares of Microsoft @40 for $400. The FRB requires you have 150% of the $400 in cash in your portfolio. That would be $600. If your account fell below that, your broker would do a margin call.

When you go to a bank for a loan, you may have cash, but it’s a liability. You owe the bank money. Treat short selling the same way. While you do get money when you sell the shares you borrowed, it’s a liability because you gotta pay your broker back. This is why you need a margin account, because you are essentially borrowing something and creating a liability.  Which gets us into the next nuance:

With short selling you can lose more money than what your account is worth. If we owned 10 shares of Facebook at $80 a share, our account would be worth $800. If Facebook went to $0, our account would be worth $0 becayse $0/share times 10 is zero. Our portfolio couldn’t be worth a negative amount, because shares can’t be worth less than $0.

But when you’re shorting, your account can go into the negatives.

Let’s say you short 100 shares of facebook at $8000. You follow the FRB requirement that you have 150% of the margin in your account. So you had $4,000 in cash, sold 100 shares of FB, and now have $12,000 of cash in your portfolio.

Let’s say markets close and FB announces amazing earnings. The stock opens the next day and starts trading immediately at $125/share. Well, if you bought those shares back right now, it would cost you $125 * 100 = $12500. Your broker would immediately do a margin call and you would be closed out immediately.

So you had $12,000 account the previous night, but you had to spend $12,500 to cover your position. You made $12k and lost $12,500k. You are $500 in the hole and owe your broker $500.

This is the thing about selling short. Stocks can go very very high, and if you’re short you’re going to lose that money. Stocks can’t go below zero, so if you buy stocks to hold long-term, you cant lose more than your account value. With shorting, you can. If the stock suddenly gaps up and catches you off guard, you can end up owing your broker money. This is not as rare s you would think so be careful.

To conclude this is shorting!  Shorting is kind of a term exclusive to stocks and ETFs, including commodity ETFs. As we will soon discuss though, when you get into commodity futures contracts – not ETFs-, you don’t really “short commodity futures.” You can sell contracts but you’re not actually borrowing the commodities. Don’t worry, we will get into these specifics in a few episodes from now. Also fun fact, if you’re a bank, you can make money from shorting stocks from the borrow. This is another topic we’ll cover in depth when we discuss what banks do in the financial sector. But just know, this is not all there is too shorting, but this episode should help you get the fundamentals down iso when you hear about it from your broker or in the news, you know what’s up.

This is such an expansive topic! So let me conclude with this: If you are a beginning investor, or even if you’re experienced, I highly highly recommend you do not short. Shorting is not investing, it’s trading ad speculating. A lot of people think trading and speculating can be fun and cool, myself included, but if you’re thinking about a long-term portfolio or retirement portfolio, it really has no place in it.

Well I hope you enjoyed this Q&A episode. If you have any questions or feedback, please shoot me an E-mail at [email protected]. This is a bit of a tough topic, but I’m really glad I got to answer it for you all.